Inventory Valuation Methods For SMEs

With inventory being your company most valuable quick assets, having a full understand of your inventory would help your organization plan perfectly. Depending on your type of business, inventory valuation differs from business to business. It is necessary that there is a quick win way to always know the ultimate value of your inventory at every point in time.

Inventory valuation is defined as the methodology of putting a monetary value on your stock or inventory items. Without this, it would remain quite impossible to ascertain how much more goods are needed, your cash conversion cycle and sales rate. An inventory valuation allows a company to provide a monetary value for items that make up their inventory. Inventories are usually the largest current asset of a business, and proper measurement of them is necessary to assure accurate financial statements.

If inventory is not properly measured, expenses and revenues cannot be properly matched and a company could make poor business decisions.

COGS (Cost of Goods Sold)

COGS are a direct cost that would flow into the production of goods.Included in COGs are raw material cost, labour ,and operating cost but does not include advertising , marketing, and delivery costs. Only cost directly related to the production of such item is calculated. From an accounting point of view, COGS are treated as expenses, so can be deducted from the company’s revenue. The result is the company’s PBT(Profit before Tax). A cost of goods sold refers to the cost of goods that have been sold to customers( reported in the income statement) while ending stock is the cost of goods that have been bought but not yet sold (reported in the balance sheet).

The three most commonly used stock valuation methods are Last-In-First-Out (LIFO), First-In-First-Out (FIFO) and Average Cost (AVCO).

Both LIFO and FIFO are cost assumption methods. LIFO assumes that the newest stock is sold first and FIFO assumes that the oldest stock is sold first. AVCO is a method that assigns an average cost of production or purchase to each product.

While they all have their benefits, the best method is ultimately the one that works best for your business. To give you an overview, let’s look at some basic observations about these techniques and how they compare.

FIFO

“FIFO” stands for first-in, first-out, meaning that the oldest stock items are recorded as sold first but do not necessarily mean that the exact oldest physical object has been tracked and sold. In other words, the cost associated with the inventory that was purchased first is the cost expended first. With FIFO, the cost of stock reported on the balance sheet represents the cost of the inventory most recently purchased.

Consider this example: Opalok CO. had the following inventory at hand, in order of acquisition in January:

Units Cost

150 $100
140 $70
80 $85

If Opalok sells 220 units during January, the company would expense the cost associated with the first 150 units at $100 and the remaining 70 units at $70. Under FIFO, the total cost of sales for January would be $19,900. The ending inventory would be calculated the following way:

Thus, the balance sheet would now show the inventory valued at $11,700.

LIFO

“LIFO” stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970s, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes in times of inflation, but since IFRS banned LIFO, more companies returned to FIFO.

In the example above, the company (using LIFO accounting) would expense the cost associated with the first 80 units at $85, 140 more units at $70, and the remaining 150 units at $100. Under LIFO, the total cost of sales for November would be $16,600. The ending inventory would be calculated the following way:

Number of units Price per unit Total
Remaining 150 $100 $15000
Total $15,000

The balance sheet would show $15,000 in inventory under LIFO.

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve (in the example above, it is $3,300). This reserve is essentially the amount by which an entity’s taxable income has been deferred by using the LIFO method.

Weighted Average Cost

Weighted Average Cost is a method of calculating ending stock cost. It is also known as WAVCOs. It takes Cost of Goods Available for Sale and divides it by the number of units available for sale (number of goods from Beginning Inventory + Purchases/production). This gives a Weighted Average Cost per Unit. A physical count is then performed on the ending inventory to determine the number of goods left. Finally, this quantity is multiplied by Weighted Average Cost per Unit to give an estimate of ending inventory cost. The cost of goods sold valuation is the number of goods sold multiplied by the Weighted Average Cost per Unit. The sum of these two amounts (less a rounding error) equals the total actual cost of all purchases and the beginning inventory.

Perpetual or Periodic management systems

Another consideration is whether to use a perpetual or periodic inventory management system. This is an important choice as it dictates how your business accounts for, tracks and manages stock on an ongoing basis. Ideally, a management system is a way of automating all the processes of inventory control and management. Periodic systems require the regular manual counting of your physical stock and don’t necessarily need inventory management software. Whilst this is okay for businesses with a small amount of stock or for those just starting out, it presents difficulties as the need for better and more accurate information increases.

Perpetual systems on the other hand, only require a manual stock count to check for obsolete, missing or damaged stock as they constantly adjust stock levels and accounting layers as sales and purchases are made. As a general rule, perpetual systems require the use of automated inventory management software in order to work effectively.

While it always comes down to what you feel is the best fit for your business, perpetual software systems offer the best all-round solutions and are becoming more and more affordable and easy to use. The best products offer a great range of functions and features as well as useful integration with existing software.